Interest rates are central to financial decisions, but the rate actually observed in markets is the nominal interest rate, the stated return on a loan or investment before accounting for inflation. To know the true cost of borrowing or the real yield on savings, economists subtract expected inflation to obtain the real interest rate, an approximation expressed in the Fisher equation as \( i \approx r + \pi^e \), where i is the nominal rate, r is the real rate, and π^e is expected inflation. This simple relationship underlies many monetary policy discussions because it links interest rate decisions to inflation expectations.
The quantity theory of money, captured by the identity \( MV = PY \), states that the money supply (M) times the velocity of money (V) equals the price level (P) times real output (Y). Velocity measures the average number of times a unit of currency is used in transactions during a period, computed as \( V = PY / M \). If velocity and output are relatively stable, the theory implies that changes in the money supply translate proportionally into changes in the price level, providing a long-run explanation for inflation.
Keynes's liquidity preference theory offers a short-run view of how interest rates are determined, arguing that rates are set by the supply and demand for money. Households and firms demand money for three reasons: transactions, precaution against unexpected expenses, and speculation on future interest rate movements. The IS-LM model combines these ideas, depicting equilibrium in both the goods market and the money market simultaneously. The IS curve represents combinations of interest rates and output at which planned expenditure equals production in the goods market and slopes downward, because lower rates stimulate investment and consumption. The LM curve represents combinations where money demand equals money supply in the money market and slopes upward, because higher output raises money demand and thus the equilibrium interest rate. Where the two curves intersect, both markets clear, identifying the simultaneous equilibrium of interest rate and output.
When interest rates approach zero, monetary policy can lose traction. In a liquidity trap, additional money injections fail to stimulate spending because individuals and businesses prefer to hoard cash rather than invest at very low returns. The zero lower bound (ZLB) describes this constraint: nominal interest rates cannot easily fall below zero because cash itself yields a zero nominal return, eliminating the room for further conventional rate cuts and forcing central banks to consider unconventional tools such as quantitative easing.